What Is Options Trading? Everything a Beginner Should Know

Options trading has emerged as the most popular means of involvement in the stock market. Whether you need an extra source of income or want to engage in risk management, speculation, or other activities, options trading provides more options than stock trading.

But since the field of options trading is rich with its language and strategies, it may appear confusing to beginners. But don't worry, once you get the basics, everything will be clear enough for you.

So, in this article provided by WealthGainers, you will find out everything about options trading including its pros and cons, strategies, and tips on how to start options trading.

What Is Options Trading?

Options trading is a financial agreement giving the buyer the right, but not the obligation, to buy or sell the underlying asset at a prearranged price up to a certain time or on a particular date.

As opposed to buying stocks, you are trading contracts that have value in relation to the underlying asset including:

• Equities
• Indices
• Exchange Traded Funds (ETFs)
• Commodities
• Currencies

Types of Options

Two main types of options are as follows:

1. Call Option

Call Option provides the buyer with an opportunity to buy an asset at a predetermined rate.

Call options are usually bought by traders when they expect the prices to go up.

Example

If there is a stock valued at ?500 and you think it will go up to ?550, buying a call option can help you earn money from the increasing price.

2. Put Option

Put Option gives the buyer an opportunity to sell an asset at a pre-determined rate.

Traders buy put options when they think that prices will drop.

Example

If there is a stock valued at ?500 and you think its value will drop to ?450, then buying a put option can help you earn money.

Key Terms for Beginners

It is crucial that you know the meaning of these terms prior to your options trading.

• Strike Price

The pre-defined price at which you can exercise the option.

• Premium

The payment made when purchasing an options contract.

• Expiry Date

The final date at which the option will still be considered valid.

• Lot Size

The total number of shares included in one options contract.

• In the Money (ITM)

The option contains intrinsic value.

• At the Money (ATM)

The strike price is similar to the market price.

• Out of the Money (OTM)

The option currently does not have intrinsic value.

How Do Options Work?

Assume the stock price is ?1,000.

You are optimistic about its future performance.

However, rather than buying the stock, you decide to buy a call option that has a:

• Strike Price: ?1,000
• Premium: ?30

In case the stock appreciates to ?1,100 prior to expiry, then the option may appreciate in value giving a chance for a profit net of the premium paid.

In the event the stock fails to perform as anticipated, your downside risk as the option buyer is limited to the premium paid.

Advantages of Options Trading

• Initial Low Investment

Options are cheaper to trade compared to stocks.

• Leverage

Your low initial investment may lead to exposure of a bigger position.

• Risk Management

Options may be used by investors to protect against adverse movements in the market.

• Strategies

Options may be traded in bull, bear, and sideways markets.

• Income Generation

Some options strategies may help to earn extra income through existing investments.

Risks in Options Trading

There are some risks associated with trading options as well.

• Time Decay

Options become less valuable the closer they get to expiration, provided that everything else remains constant.

• Volatility

A very volatile market may impact the prices of options significantly.

• Complexity

Some of the trading strategies use several options positions and demand thorough knowledge of the market.

• Risk of Great Losses

Some of the trading strategies – especially some of the option selling strategies – have great risk of loss for the trader.

Common Options Trading Strategies for Newbies

• Buying Calls

Good for a bullish market condition.

• Buying Puts

Ideal for a bearish market condition.

• Covered Call

Individuals who have stocks use covered calls to earn extra income from selling call options.

• Protective Put

Used to minimize risks in the stock held.

Who Are Good Candidates for Options Trading?

Options trading is recommended for:

• Newbies ready to learn

• Active traders
• Long-term investors
• Portfolio managers
• Seasoned traders using complex strategies

Advice for Beginners

Before your first investment, here are some tips:

• Learn all the basics.

• Know all about the risks.
• Start with simple strategies like call and put options.
• Practice with a demo account where possible.
• Apply risk management and stop-loss if required.
• Do not invest what you cannot afford to lose.
• Be aware of market news and economic events.

Common Beginner Mistakes

Here are some mistakes made by many beginners:

• Trading without a strategy

• Ignores risk management
• Overuse of leverage
• Chasing profits
• Does not know about the expiration of the option
• Trading with emotions

Not making these mistakes will help you in decision-making and discipline.

Is Options Trading Better Than Stock Trading?

Both have some pros and cons.

Features                                  Stock Trading                Options Trading

Amount of Capital Required                     High                                             Low

Leverage                                                   None                                           Yes

Risk                                                        Moderate                              Varies with strategy

Flexibility                                                  Limited                                         High

Hedging                                                    Limited                                      Excellent

It all depends on your personal financial situation and experience.

Frequently Asked Questions (FAQs)

Is options trading suitable for beginners?

Yes. Beginners can learn about options trading and the associated risks before starting with basic trading strategies.

How much should I have in my account to start options trading?

This depends on the market, the broker and the particular strategy that you use. Use the money that you are willing to risk.

Is options trading safe?

No. Although buying options means that the trader’s maximum loss is the price he paid for the option, some selling strategies carry very high risks.

Will I earn money through options trading?

Options trading provides many profit-making opportunities; however, there are no guarantees of profits. It all depends on market conditions and the trader’s skills.

Which options strategy should I use as a beginner?

Many beginners learn about the basics of call and put buying strategies before proceeding to more advanced strategies.

Final Thoughts

Option trading can prove to be quite a flexible way to get into the world of trading. It will enable traders to achieve a variety of purposes through option trading, such as speculation, but option trading also involves certain risks which must be well understood.

If you are a beginner in option trading, make sure you concentrate on developing a solid knowledge base and gaining experience through using simple option trading techniques. Do not chase fast profits and make all of your trades according to a clearly defined strategy.

We at WealthGainers aim at helping traders and investors expand their knowledge base by providing reliable information, valuable insight into the market, and other resources suitable for beginners.